The financial investment industry has long recognized the need for tax-advantaged, investment products. However, the investment industry has traditionally managed most taxable and tax-exempt financial portfolios in a similar fashion, even though it is clear that trades that are considered good for tax-exempt portfolios may not be appropriate for taxable portfolios.
In the current investment market environment, investors seek to capitalize on economic growth primarily through mutual funds and individual stocks. The growth in both of these products over the last two decades affirms the widely held belief that it is important to have exposure to the equity markets in any diversified asset allocation program. Mutual funds have traditionally catered to the broad retail market, where investors seek investment advice and active management. However, in mutual funds, the opportunity to manage for tax efficiency is virtually eliminated, as tax-exempt and taxable investors are combined into the same pool of assets. Dilemmas for the taxable investor include 1) the inability to restrict short-term capital gains; 2) the hazard of buying into yet unrealized gains; 3) the lack of control over the timing of gain realizations; and 4) the inability to pass losses from a fund to offset taxable events in the rest of the investor's portfolio.
Indeed, a significant downside to investing in mutual funds is the tax treatment of gains and losses. Market volatility and the movement of assets in and out of funds have resulted in many funds generating significant capital gains distributions. When individuals own mutual funds, they receive distributions for all the gains realized through trading. This means that even if the investor does not sell any fund shares, he or she may have to pay taxes on the gains that the fund manager has realized. Indeed, most alarming is the situation that may occur when an individual investor invests after a fund has accumulated significant unrealized gains. If the fund then has a price decline, causing other investors to exit the fund, the fund manager must sell stock to generate the cash needed to pay out selling shareholders. The result is that the new investor can actually lose money, and owe taxes on gains that he or she never received. These tax issues make it advantageous for individual investors to own individual securities, although most will continue to seek the professional management, reduced (or shared) costs, and diversification that is inherent in mutual funds.
By owning individual equities, investors do not inherit other investors' capital gains as they do in mutual funds. For investors seeking a managed account solution, so-called wrap accounts provide a managed financial portfolio to individual investors. However, financial services offering management of individual portfolios have only been available to high net worth investors. Even as to most individually-managed, separate account programs, however, managers typically consider tax implications at a very high level, ignoring each clients cost bases associated with their holdings, changes in tax rates and other relevant tax information specific to each client. Constructing a financial portfolio involves considerable time and effort. For this reason, most managers of wrap programs manage all client portfolios for a given style in the same manner, by constructing a model portfolio that is adhered to for all accounts. While it may be possible to apply certain rules in constructing individual client portfolios (for example, no sin stocks), accounts are generally not customized for each client based on individual tax situations. Tax considerations, where taken into account at all, are typically made across all client accounts at a model portfolio level. Moreover, even the large majority of managers and wrap programs that claim to be tax aware or tax efficient generally just minimize turnover, or match gains and losses as they make trades within the model portfolio.
Such a management process ignores the genuine differences among clients, such as account costs positions, tax rates, and other taxable events in their lives (for example, gains and losses outside the specific account being managed). For taxable accounts, these wrap programs do not provide tax-optimal investment management for individual investors. To optimize after-tax returns for each client, an investment program must consider many circumstances specific to the client—e.g., the investor's tax bracket, gains or losses outside the managed funds to match against investments in the managed portfolio, the respective cost bases for equities in the portfolio, etc. Integration of all necessary information into portfolio management has been a labor-intensive process. Accordingly, due to the complexity involved in maximizing after-tax returns, only multi-million dollar financial portfolios have received the individualized attention required to make the best trades for each individual taxable client.
Market pressure from individual investors, the growth of Internet-delivered solutions, and reduced transaction costs for trading, accounting and other support functions are driving the development of a new category of low-cost, individually diversified portfolios. The emergence of these products is proving to be a viable alternative for individual investors who want to avoid the tax issues of mutual funds and manage their own accounts. The products help individual investors select pre-packaged “folios” or “baskets” of stocks to meet their investment objective. While these products allow individuals to achieve diversification benefits that are normally only available in mutual funds, they are generally either passive products, or must be managed by the individual investor. For those that seek management from established money managers, these new basket products do not provide a solution.
In light of the foregoing, a need exists for asset management systems that enable tax-optimized management of individual financial portfolios in an efficient and cost effective manner. For instance, a need exists for asset management systems that allow for tax-optimized managed account products that are available to lower net worth investors.